COLUMN-Hedge funds yearn to dance with Brent-WTI again:Campbell

Reuters Staff

6 Min Read

(Robert Campbell is a Reuters market analyst. The views expressed are his own)

By Robert Campbell

NEW YORK, Nov 6 (Reuters) - As 2012 winds down, traders’ thoughts turn to next year. For many, betting that the yawning price gap between Brent and West Texas Intermediate crude oil will narrow, a trade that went horribly wrong this year, looks too tempting to pass up.

Even those badly burned by past spread trades are salivating at the opportunity, as the prospect of outsized returns from a narrowing some time in 2013 is hard to pass up.

A bet on WTI versus Brent, if successful, some buysiders argue, offers a lot of “alpha,” or returns over and above what the broader market generates.

Alpha is the lifeblood of hedge funds, and the only real justification for fat management and performance fees. Market returns, or worse, give clients itchy feet.

So with commodity indexes widely expected to boost Brent weightings at the expense of WTI next year (the S&P GSCI has already said it will do so: [ID:nL1E8M60FG]), any outperformance by WTI offers a chance to deliver a return that thumps the market benchmark.

But after getting fried this year by wrong-way bets on the spread, there is a lot of nervousness on the buyside. No one wants to be the muppet. Traders recognize there are plenty of risks in this trade.

First up is refinery maintenance. Oil major BP (BP.L) began a long-awaited shutdown of a large part of its 337,000 barrel per calendar day Whiting, Indiana refinery for an upgrade that is expected to slash demand for crude oil in inland North America for three months or so by up to 250,000 bpd.

That should depress WTI prices and trigger increases in stockpiles at Cushing, Oklahoma, the delivery point for WTI futures.

Planned work elsewhere in the Midwest is expected to exacerbate the impact of the Whiting shutdown by further cutting into refinery buying of WTI and other crude oils that compete with it for space in the market.

SPRING IS IN THE AIR

The heavy maintenance slate has convinced many traders to hold fire on a bet on the spread. Brent’s susceptibility to quick upward moves in response to even minor problems with North Sea production adds further risk.

With more refinery turnarounds expected to temporarily cut into midcontinental crude oil demand in the spring of 2013, hedge funds are looking to the later months of the second quarter of next year as a potential entry point into the narrowing Brent-WTI trade.

By then, with refinery maintenance turnarounds out of the way, the fundamental picture ought to look more favorable, the reasoning of these players goes.

Already the market has briefly shown episodes where Cushing is no longer a market of last resort. The fact that the Spearhead pipeline from Chicago to Cushing will not run full this month is one sign.

Another is the periodic narrowing of the gap in pricing between North Dakota’s Bakken Blend crude BAK- and Light Louisiana Sweet LLS- to levels that at times suggest rail capacity is sufficient to clear the market. [ID:nL1E8KH7T8]

Other pipeline projects that will divert oil from the Permian basin away from Cushing, such as Magellan Midstream Partners’ (MMP.N) Longhorn project, should offer further support.

Finally, the 250,000 bpd expansion of the Seaway pipeline from Cushing to the Gulf Coast should offer the final piece of the puzzle, draining huge amounts of cheap oil out of Cushing towards the Gulf Coast.

TOO GOOD TO BE TRUE?

On paper, it looks like a solid trade. But not one without risks of failure on a grand scale.

After taking a battering this year on the spread, traders ought to be more aware of the risk that shale oil production surprises to the upside.

The boom in North Dakota crude output this year has blown away all but the most enthusiastic predictions. Might it not surprise us again, especially as technology improves? [ID:nL1E8LQ5L1]

Many analysts understand that the big risk is not that North Dakota surprises but that another area with no other market outlets but Cushing does.

There are a lot of “pent up” barrels just waiting to flow into the WTI hub from plays a lot less mature than the Bakken shale in North Dakota.

The middle of next year will see the startup of a new 175,000 barrels per day capacity pipeline into Cushing from the Mississippi Lime area in northern Oklahoma and southern Kansas, backed by heavyweight Plains All American Pipeline LP. (PAA.N)

And there is plenty of other oil that wants to get into Cushing. Look no further than the support given by producers in Colorado’s Denver Julesburg Basin for an expansion of the White Cliffs pipeline, which is now expected to be completed in the first half of 2014.

Similarly, the risk is that projects to divert supply from the Permian basin away from Cushing only succeed in eliminating bottlenecks at places like Midland, Texas.

In other words, Permian producers still ship the same amount of crude to Cushing but earn a bit more as the downstream bottleneck in East Texas has been relieved. Ultimately the risk in the trade boils down to two things: there is huge uncertainty about the speed of the increase in Canadian and U.S. oil production and infrastructure seems certain to lag output at least part of the year.

Until there is a surplus of shipping capacity in the North American interior, Brent and WTI will remain fundamentally disconnected commodities, that will ultimately obey the logic of their own markets.

That disconnect makes it impossible to say what the “right” number for a Brent-WTI spread is. That is the true danger of this trade.

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